Opinions on GSE Culpability Conflict at Housing Conference

In mid-November the Federal Reserve Bank of St. Louis sponsored a conference on the "Past, Present, and Future of the Government Sponsored Enterprises (GSEs)".  The invitation-only event featured six presentations on the title topic provided by participants from colleges and universities and one conservative and one liberal "think tank."  The papers broke down into two categories which can be broadly described as "how did we get into this mess?" and "what can we do to get out of it?" 

Bank President Jim Bullard in his opening remarks said that the U.S. government has often modified the structure of housing finance after a crisis, pointing to the expansion of mortgages from the five to seven year non-amortizing balloons that predominated before the Depression to 20 to 30 year, fixed-rate loans afterward.  It was the Depression that also led to the creation of Fannie Mae.  

Bullard said the "extent of Congressional meddling in this market has been astonishing to the point where one can barely identify what the private sector outcomes would be in the absence of intervention," and urged the government to let the private sector provide the bulk of housing finance going forward.  It was "incentive-distorting" government programs and taxpayer guarantees that caused the current system to collapse; programs that meant well, he said, but ended up costing everyone dearly.  "It makes little sense to try to design programs that subsidize everyone.  If everyone is subsidized, then no one is subsidized.

Bullard laid out his principles for reforming the process:

• Government subsidies to lower-income and first time buyers should be disentangled from more broadly defined housing finance and the function regulated alongside FHA and Ginnie Mae.
• The flow of credit to specific sectors of the economy should be done so as to shelter taxpayers from the risk of insolvency.
• Excess leveraging of home values must be compensated with other factors such as default insurance.
• Recourse regulation should be considered similar to Europe's which does not permit discharge of mortgage debt.
• Mortgage pooling should be constrained to loans with similar characteristics and the financial intermediaries required to hedge MBS portfolios through insurance or other means.

In evaluating the causes behind the failure of the GSEs, some conference presentations did not support Bullard's theory about the "incentive-distorting" nature of government intervention.  Jason Thomas, of the Department of Finance and Robert Van Order, holder of the Oliver Carr Chair in Finance and Real Estate, both of George Washington University presented their paper on Housing Policy, Subprime Markets and Fannie Mae and Freddie Mac:  What we Know, What we Think we Know and What We Don't Know.  The two said that the current narrative about the financial crisis tends to put particular emphasis on the affordable housing goals that the GSEs were required to meet; the theory being that this pushed them into excessive risk taking and into making the market in subprime loans.  "That Fannie and Freddie required an expensive taxpayer-financed rescue just years after they were identified as posing a systemic risk is consistent with this line of reasoning."  This, however, the pair said is not supported by their data. 

Their study found that the growth of the subprime market was largely a non-GSE phenomenon occurring outside of normal mortgage origination channels and funded by non-agency or private label securities (PLS).  "The GSEs did build a large portfolio of AAA PLS, probably in response to affordable housing goals, but such investments were unlikely to have had much of an impact on subprime mortgage origination, and were not a large share of their credit risk."

Where the GSEs did increase their risk-taking it was not in pursuit of housing goals.  They did not purchase non-traditional mortgages in any quantity until the market had peaked in 2005 and then these were predominantly Alt-A mortgages made to borrowers with high credit scores and substantial equity.  Subsequent loses can be attributed largely to the acquisition of these Alt-A and other "prime-like" paper at the height of the bubble.  While they do not have the data to support their conclusion, they feel that a large share of the GSE losses were due to property value declines.

Shawn Moulton, Department of Economics, University of Notre Dame also debunked a GSE-housing collapse narrative, saying there is little econometric evidence linking the 1992 GSE Act which established low-income housing goals to relaxed GSE or lender standards.  Moulton uses loan application level data to examine whether the affordable housing goals altered the probability that 1) a loan application is originated, 2) an originated loan is purchased by a GSE, or 3) an originated loan is a sub-prime or "high-price" loan.  He also used census-tract level data to examine the effect of the GSE Act on foreclosures, vacancies, high price loans, and other housing outcomes.

The three goals set forward by the GSE Act define the percentage of GSE purchases that must be from

 a. very low-income borrowers and low-income borrowers living in low-income areas - the Special Affordable Goal (SAG);

b.  lower income borrowers - the Low and Moderate Income Goal (LMIG);

c.  low income and minority neighborhoods - the Underserved Areas Goal (UAG).

Moulton found that the SAG increased GSE purchases from very low-income borrowers by four percent but had no effect on mortgage lending and found no evidence that the LMIG or UAG altered purchase or mortgage lending decisions.  Finally, using the census tract-level data he found no relationship between the GSE Act's goals and increased foreclosures, vacancies, or other housing outcomes. 

Moulton concludes, "As I find no evidence that the GSE Act increase loan originations, I conclude that the GSE Act could not have caused the recent housing crisis.  Hence, attention should be moved away from the GSE Act to other potential causes of the crisis."

Dwight M. Jaffee of the University of California, Berkeley, however, does blame the GSEs and their housing goals for a portion of the problem.  His research found that what he defined as high-risk mortgages made up about 43 percent of the total mortgage acquisitions by the GSEs in 2007,  This domination of the market for high-risk mortgages is, he said, just the opposite of what would be expected of government sponsored enterprises with a public mission to stabilize the mortgage market.  "In fact, the GSEs piled onto an already highly overheated market, thus creating terrible consequences for themselves, the overall housing and mortgage markets, and the economy."

Jaffe said that the GSEs took these risks, even at a time when the extremes of the housing market were already apparent, because subprime mortgages offered above average interest rates and the GSEs felt they could evaluate and tolerate the risk and investors in GSE debt and MBS felt protected by the implicit guarantee.  In addition, the expansion of the subprime market drained the prime market and the GSEs were unable to maintain their usual portfolios which caused a decline in their stock price.  The aggressive acquisition of sub-prime mortgages was an attempt to regain market share.  Finally, the acquisition of high -risk mortgages could help the GSEs reach their housing goals.

This risk-taking behavior was fully predictable, Jaffee maintains, because of the incentives available to the GSEs.  The implicit guarantee allowed them to issue almost unlimited amounts of debt and MBS at interest rates that exceeded comparable Treasury debt by small spreads.  In this situation, enterprise profits and management bonuses could be maximized by expanding the volume and degree of risk-taking. 

At the same time, government studies vastly underestimated the cost to the taxpayers of the risky behavior with most studies, even those as late at 2008, projecting that future subsidies to the GSEs had only a minuscule chance of exceeding $100 billion.  The losses are now expected to exceed $200 billion. 

Jaffe and three other speakers presented conference attendees with a variety of suggestions for restructuring the GSEs.  Those will be summarized in a future article.